Week Ended: April 27, 2007

A Juncture in the Path

In the past, many central banks in Asia have taken their cues from the actions of the U.S. Federal Reserve. However, even as the Fed raised rates from 1% to 5.25% between mid 2004 and mid 2006, most of Asia's major economies did not follow in lockstep. Back in 2004, we stated our belief that Asia's economies were able to accommodate somewhat higher levels of inflation, especially if those same economies intended to hold their currencies relatively stable versus the dollar. However, by August 2006, the environment in Asia ex-Japan had changed. Evidence of production bottlenecks surfaced in some of the larger economies, and signs of excessive demand emerged. Since then, the U.S. Fed has held rates steady at 5.25%;meanwhile, all three of Asia's largest economies (Japan, China and India) have undertaken rate increases (0.25%, 0.27% and 0.75% respectively) and each has adopted a more "hawkish" stance towards signs of inflation. In China and India, where capital markets are not necessarily as responsive to interest rate signals, monetary authorities have also implemented alternative measures to tighten money supply, such as credit rationing.

Even as talk of inflation is rife in places like China and India, there is one very substantial shift in the economic landscape that might alter the forward path of both inflation and interest rates: currency flexibility. In past years, Asian currencies have been notoriously stable versus the dollar (with a few notable exceptions, such as the Korean won). But over the last year and a half—and especially the last few months—currencies in the region have begun to exhibit far more flexibility. Increased currency flexibility may counteract some inflationary pressures, and this in turn may allow Asian central banks to pursue more modest rate increases. This scenario was evident in India since mid-March, where the Indian rupee has appreciated over 8%, touching its highest level versus the dollar in 9 years. Though China is often criticized for its reticence to allow its currency to trade more freely, it too has allowed its currency to strengthen over the last two years.

Should the trend towards greater currency flexibility continue, we think it will be quite positive for the region's long term economic health. However, in the short run, it is likely to induce more volatility: expectations for interest rates in the region—which were largely set in the past by the actions of the Fed—are no longer quite so clear. We look forward to what may be a new path in the evolution of Asia's capital markets, with all the attendant risk and reward that path might entail.

		Key Central Bank Rate-04/07		Change From 08/06*		Inflation**		Economic Growth		Currency Appreciation vs. Dollar+
China		6.39%		0.27%		3.3%		11.1%		3.0%
India		7.75%		0.75%		5.7%		8.6%		14%
Japan		0.50%		0.25%		-0.2%		2.3%		-1%
South Korea		4.50%		0.00%		2.2%		4.0%		4%
Thailand		4.00%		-1.00%		2.0%		4.2%		16%
U.S.		5.25%		0.00%		2.8%		3.1%		-

*As of 4/25/07
**As of 3/30/07
+ A change in local currency exchange rate, relative to U.S. Dollar between 08/31/2006-04/25/2007

Source: Bloomberg


Regards,

Andrew Foster
Director of Research, Portfolio Manager
Matthews International Capital Management

 

 

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